Condensed Chapter 9 Schiller

Component Parts of GDP?

What allows GDP to grow?

• Consumption increases• Investment increases• Government spending increases• Exports exceed Imports.

What is Disposable IncomeYd

Amount of money we have to spend after taxes.

2 Things can do with money?Yd = C + S = 1

Some Simplifying Assumptions in a

Keynesian Model

Consumption + saving disposable income

Saving disposable income – consumption

The Proportion of Disposable Income spent

on Consumer goods and services = APC• Average Propensity to Consume (APC)

oReal consumption divided by real disposable income

oThe proportion of total disposable income that is consumed

APC =Real consumption

Real disposable income

Work this problem If: Disposable income = $40,000Consumption is $30,000What is the APC?

Answer

30,000 / 40,000= ¾ = .75 = APC

What is APS?Remember Consumption + Savings = 1So without working the problem, you already know that savings is .25But to find the formula – $30,000 - $40,000 = $10,000Divide 10,000 / $40,000 = l/4 = .25

Another problem for practice

Disposable income = $20,000APS = $1,500What is APC?

Subtract $1,500 from $20,000 and you get $18,500Divide $18,500/$20,000 = .925 = APCDivide $1,500 / $20,000 = .075 = APS

.925 + .075 = 1

• Average Propensity to Save (APS)

o Real saving divided by real disposable income (DI)

o Saved proportion of real DI

APS =Real saving

Real disposable income

MPC =Change in real consumption

Change in real disposable income

When you think of Marginal, think change

from one number to another.• Marginal Propensity to Consume (MPC)

oThe ratio of the change in real consumption to the change in real disposable income

Marginal Propensity to Consume

How much will consumption change in

response to change in disposable income?

• Change in Consumption/Change in Income

▲C▲Yd

Problem to solveYear Income Consumption

1998 $30,000 $23,000

1999 $40,000 $31,000

Answer

▲ Income = $10,000▲ consumption = $8,0008,000/10,000 = .8MPC

MPS = $2,000/$10,000 = .2

The Multiplier• The Multiplier:

-- The multiple by which an initial change in spending will alter total expenditure after an infinite number of spending cycles;

An increase in spending by one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount.

The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income.

The size of the multiplier increases with the marginal propensity to consume (MPC).

• In evaluating the importance of the multiplier, one should remember:

taxes and spending on imports will dampen the size of the multiplier;

it takes time for the multiplier to work; and,

the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

The Multiplier

Keynes rejected the classical notion of self-adjustment, (????) and he predicted things would get worse once a spending shortfall emerged.

Example:• Business expectations of future sales worsens.• Business investment is cut back.• Unsold capital goods begins to pile up (includes

office equip. machinery, airplanes, etc.)• *this is an “undesired” change…• Worsened sales expectations causes decline in

investment spending that shifts the AD curve to the left leading to pileups of unwanted inventory.

Multiplier Formula

Multiplier is

______1_____1 – MPC

When money is spent by someone, it becomes someone else’s income. When someone spends a dollar, perhaps someone who received that dollar would spend 80 cents..next person would spend 64 cents…If you add up the spending created by that one dollar, it will add up to four or five times that dollar… hence “the multiplier”

The multiplier principle applies in reverse also. (decrease, yields reduction) (money in shoe box)

Marginal Propensity to Consume is the keyThe multiplier builds on the principle that one

individual’s expenditure becomes the income of another.

*Income increases- we spend some on “more stuff” In turn consumption expenditures on “stuff” will generate additional income for others who will spend part of their income on “stuff” also.

There is a direct correlation between expenditure multiplier and MPC.

The Multiplier Process

1. $100 billion in unsold goods appear

3. Income reduced by $100 billion 4. Consumption reduced by $75 billion

5. Sales fall $75 billion6. Further cutbacks in employment or wages

7. Income reduced by $75 billion more

8. Consumption reduced by $56.25 billion more

Factor markets

Product markets

Business firms

Households

9. And so on

2. Cutbacks in employment or wages

ExpenditureStage

Additional

Income(Dollars)

Marginal

Propensity

To Consume

Additional

Consumption(Dollars)

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

1,000,000 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085

225,253

750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 56,314

168,939

Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10

3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4 3/4

Total 4,000,000 3,000,000 3/4

All Others

The Multiplier Principle

• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% 3/4).• Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until . . . effectively, $4 million is spent in the economy.